Tax Treaty Changes: The Swansong of High-Tax Europe

Two big changes in international tax treaties have been in the works for some time: the BEPS (Base Erosion and Profit Shifting) Action Plan by the OECD, and debates within the EU with the intent to achieve greater tax harmonization.

One does not need to be an expert on either to draw the conclusion that the proposed changes (a) are a signal of the enormous strain that Western national budgets are under, and that (b) the proposed cures are more likely to kill the patient than to stimulate a return to balanced budgets, fiscal discipline, and increased competitiveness of the developed nations.

Let’s discuss the two initiatives in turn:

The BEPS Action Plan by the OECD tries to address the problem that international tax treaties favor an assessment of where profits are ‘booked’ rather than where they are ‘generated’ when deciding in which country tax is due. As an example, Amazon organises order fulfillment from a Luxembourg entity, while the majority of customers of course sit in other large countries, and the physical delivery may not even originate from Luxembourg. Starbucks Europe collects intellectual property royalties in the Netherlands from any Starbucks sale anywhere in Europe. The ‘trick’ is to establish entities in low-tax jurisdictions, which then charge a fee to their sister companies in high tax jurisdictions, for ‘services’ which are superficially valuable but are both cheap to produce and extremely scale-able (like electronic order processing or royalty charges). Activities are undertaken de facto in one country and de iure taxed in another.

The ‘cure’ that the BEPS Action Plan envisages is twofold: One is to reduce tax competition between countries: if tax rates were more harmonised, the opportunities to ‘game the system’ would dwindle. The second is to switch to a set of rules which reflects more closely the actual distribution of substance of business activities in the different countries in which a multi-national company operates. The first reflects a view on tax competition being inherently bad, while the second is more balanced and tries to increase tax fairness between countries.

The fairness point is a strong one to be taken seriously. But the first point is more about tax competition being inherently bad, and that is a fallacy: Restricted competition, in any market, benefits the ‘haves’, and hurts the ‘have-nots’. It enshrines established economic power relationships by protecting the incumbents. The ‘strong’ (i.e. economically and/or socially ‘attractive’) countries who can and do already extract higher taxes from a willing population naturally want their tax revenue capacity protected. But this is no different from any strong economic agent asking for additional protection against competition. Lack of competition overall leads to lack of competitiveness. It engenders rent-seeking behaviour and subsidizes the incumbant at the expense of the nimble and nifty newcomer who is trying to ‘make it’ and move up the economic ladder. Tax competition, on the other hand, allows weaker and/or smaller nations to create competitive niches for themselves, and develop selective competitive advantages, as — even the morals-obsessed Adam Smith would have agreed — anyone should seek to do.

Free trade, i.e. increased competition, has moved more people out of poverty in the last 20 years than all the development aid of the 50 years before has done. Countries like India and China did not shrink their poverty gap by raising taxes on international companies. In fact they did the opposite: they increased their competitiveness in several ways: by opening up to foreign trade, by increasing connectivity (electronic and physical), and in doing so lowered red tape, corruption, and taxation, albeit slowly and from a high level.

Three years ago, in my article on outsourcing in India, and in a talk I gave in Bangalore, I presented copious research evidence that the increased competitiveness of India and China, rather than being a threat, has in fact helped to spur overall economic growth in the West too.

The second point of the BEPS Action Plan, of shifting the basis of taxation in each country towards reflecting the balance of ‘economic substance’, has a certain social justice appeal. But, just like any protective social measure, it comes at a cost: It would actually permit countries like India and China to raise taxes on activities which are currently taxed mostly outside their jurisdiction. Neither these countries themselves, nor of course the rest of the world is particularly keen on this outcome, but this is what would happen. It may actually lead to lower tax revenues of some economic activities in the West. The second consequence is that, a coercion to pay more tax in particular countries is at the same time an encouragement to move economic substance elsewhere. This may lead to yet lower tax take than expected, and to losses of jobs and of competitiveness in precisely those countries who most seek the BEPS protection.

Moves towards tax harmonization in the EU:

Arguments for increased tax harmonization have led to heated debates ever since 1998, when France and Germany called for “rapid progress towards tax harmonization in Europe”.

Currently, the provisions for taxation in the EU are laid down in Articles 110 to 113 of the Treaty on the functioning of the EU. Their main focus is the smooth operation of the single market. As long as there are no obstacles to free trade, member countries can choose the most appropriate system for themselves. The subsidiarity principle, on the other hand, means that coordination can be enforced where action at the member state level does not lead to an effective solution.

An excellent, and very quantitative research by Fabio Wasserfallen from the University of Zurich demonstrates the historic trends of the harmonisation debate within the EU. The EU-12 and EU-15, for example, had stronger support for tax harmonisation than the enlarged EU had. The introduction of the single currency subsequently increased the level of support for tax harmonisation.

What is really important here, however, is to distinguish between tax harmonisation and tax centralisation. The US, for example, does not have the former, but it has the latter. There is no requirement for US federal states to harmonise their state taxes, but there is a federal tax on top of state taxes and local taxes.

Recently, de Galhau and Weidmann made their case for a deeper financial integration of Europe. Given where they are positioned, right in the heart of the European integration project, in the governing council of the ECB, this is not surprising. Their arguments, as they stand, are academically sound, but they are not politically feasible. The Euro crisis not only exposed the lack or the elecorates’ willingness to integrate further, but it actually fuelled discontent with the European project even more. To drive further top-down integration in this context will stoke the fires of nationalism even more.

It is a known fact that a currency union needs at least three out of four components to be sustainable: freedom of movement of capital, freedom of movement of labor, a common fiscal policy, and a common monetary policy framework. But how exactly does the common monetary policy fail in the absence of the other components? Because (a) local divergences in fiscal policy, labor market conditions, and competitiveness cannot be absorbed by investment in poorer regions where it would be more attractive to produce goods or deliver services from, and because (b) lack of mobility of labor makes it hard for booming economies to slow down their inflationary wage pressures and for faltering ones to recover employment levels without massive wage deflation. But most importantly, the common monetary policy fails because there is no political solidarity at the level of the electorate and there is no significant central budget in place to counter-act the economic divergence which the common monetary policy produces. This has been woefully exposed in the recent crisis. The EU is not only tired of helping Greece, it is tired of the political cost of doing so. And Greeks are not only tired of excepting handouts instead of declaring bankruptcy: They are also getting tired of the political cost of going along with more and more bailout packages. In the absence of a sizeable central budget, balancing payments are at the mercy of voters’ whims, and — since the Greek crisis — we now know how this debate will end every time: austerity and punishment, with no chance or redemption, and increased political discontent between the member states.

This is an entirely self-inflicted problem. Ever since the beginning of the European project, the Union has served as a scapegoat for unpopular but necessary structural decisions. Ever since the beginning of the European project, elections have been fought hard at the national level and largely ignored even by the political parties themselves at the European level. The result is a very low level of (a) buy-in to European policies, and (b) no effective ‘social contract’ across national borders. As a consequence, the central budget is just large enough to pay for the central bureaucracy and farming subsidies, but not much more. Without the necessary social cohesion as a precondition, and without a reasonable central kitty, there can be no functioning monetary and fiscal union. The design flaw was to simply assume that a unified political framework will create the necessary buy-in, and member states will voluntarily pick up the bill for any collateral damage from time to time. It has done exactly the opposite: By forcing conditions that require constant interventions like bail-outs and transfers for which there is no budget and no buy-in, it has lowered the buy-in for pan-European solidarity even further. The Euro crisis has exposed a simple truth: that a union dictated from above sows the seeds of its own, possibly violent but certainly disruptive destruction.

If Europe wants to integrate, four things must happen to lay the ground: the voters need to become Europeans first and nationals second. This will take generations and top-down integration has had the opposite reaction so far. The second is that European ‘areas’ (not necessarily nations) must lose their fear of being in competition with each other, for jobs, for labor, for taxes, for regulations and laws. Third, the central budget needs to increase so that solidarity can be enacted by budgets which are already in place rather than one-offs which need to be voted through each and every national parliament every time. Lastly, countries must be able to compete against each other, for resources, labor, and tax. Only when (a) every country is able to set its own economic agenda while (b) the Eurozone has the money it needs to function will the pressure for integration stop being an impediment to growth and a danger to cohesion. The whole point is therefore simple: We need tax centralisation, not tax harmonisation. We need to learn from the US model. Tax centralisation would encourage economic convergence without threatening social cohesion further since poorer countries would benefit disproportionally, in the same way as poorer regions within countries benefit from a national tax system. Also, voters and national politicians themselves would not constantly get in the way of fiscal transfers, simply because the money will be there, centrally. Tax harmonisation without a central pot, just like the monetary union itself, increases divergence and endangers social cohesion between member states.

Eurozone states are certainly able to increase their contribution to the EU funds, with the increases earmarked for Eurozone costs only. EU contributions are currently at around 1% of GDP, so there is probably room to double this. Enforcement of a moderate Eurozone tax is not an issue if it is paid by the member states directly rather than by the economic agents (the voters and the companies) within these states.

Fiscal discipline does not come by top-down dictat. It come from tax competition between states, and from the ability to go bankrupt as a country. Both conditions exist in the US, and neither exists in the Eurozone. This is necessary and healthy for overall competitiveness of an economic area.

Tax harmonisation, and the OECD’s BEPS Action Plan are a death embrace of economies desparate to maintain an unsustainable level of ‘government vs. markets’: In Europe, some 50% of the economy is ‘controlled’ by state budgets on average, a much higher level than in the rest of the world, and historically an aberration. A non-partisan and dispassionate presentation of the comparative numbers can be found in Vito Tanzi’s excellent book “Governments vs. Markets”.

Arguing that markets would be more efficient with less competition is a perversion of simple economic facts, and this is just as true for tax competition between countries as it is in any other area where economic agents compete. Harmonization only delays the day or reckoning for those countries which run unsustainable budgets, it fuels increased economic divergence, and does nothing to further a social contract between Eurozone member states. Tax harmonisation will delay the day of reckoning for those who run unsustainble budgets, allowing them to do so for longer. Which only means the day of reckoning would shape up much worse when it finally does arrive.